But today when we are talking about Real Mortgage Rates we are not talking simply about the inflation adjusted price of a mortgage. To calculate the real cost of your mortgage you must also take the appreciation of your house into account. So for example if your mortgage rate is 5% but your house appreciates 5% your real mortagage rate is zero. The formula for Real Mortgage Rate (excluding inflation) is mortgage rate (M) minus appreciation (A) equals Real Mortgage Rate (RMR) or M – A = RMR.

The Real Mortgage Rate and the Housing Bubble

Back in 2005 at the peak of the housing bubble housing prices were appreciating at what in hindsight were unsustainable levels. In those days, home prices were increasing at 17% per year.

So if 30 year mortgage rates were at 6%… the real cost of owning your home was 6% minus 17% appreciation or a negative 11%. In other words, by borrowing 6% you could net 11% profit on your home. No wonder people were buying houses like crazy. The real mortgage rate was -11%! Had the federal government not subsidized loans through Freddie and Fannie… mortgage rates would probably have risen in step with housing prices and there wouldn’t have been a bubble.

Just five years later we were at the other end of the spectrum. Mortgage rates had fallen to 5% but house prices were no longer appreciating at break-neck speed. As a matter of fact housing prices were actually falling at ironically -17% the exact rate at which they were rising five years earlier. So in 2009, the real mortgage rate was 22% that is the mortgage rate 5% minus the negative appreciation rate (-17%) =22%. No wonder no one wanted to buy houses when the real mortgage rate was 22%. Who in their right minds wants to buy a rapidly depreciating asset and borrow money to do it?

Currently in 2011 mortgage rates have fallen to around 4% and housing depreciation has fallen to about 5% per year according to Zillow.com the nationwide housing tracker. That brings the real mortgage rate to 9% which is 4%-(-5%)= 9%. This of course is much better than 22% but still a long way from 2005’s -11%!

Inflation Effects on Real Mortgage Prices

To get the true picture, we need to add one more factor to the real mortgage rate and that is the effect of inflation on the above calculations. Back in 2005 the average annual inflation rate was 3.42% so you were paying off that mortgage with cheaper dollars. So in reality the real mortgage rate was not -11% but actually -11% minus 3.42% or about -14.4%!

In 2009, the average annual inflation rate was a deflationary -0.34% so it actually increased the real mortgage rate making it even worse. It was 22% – (-0.34%) = 22.3%.

And now in September of 2011 the real mortgage rate is 9% – 2.91% or about 6.1% which is better but still not great.

During the 40 years from 1971 to 2011 housing prices appreciated an average of 4.81% a year, mortgage rates averaged 8.85% and inflation (excluding housing) averaged 4.11%. This would result in a real mortgage rate of 8.85% – 4.81% – 4.11% = -0.07% so it would be mildly beneficial to own a home over that period. As a matter of fact the year 2008 came very close to this average. The mortgage rate was approximately 7%, housing appreciated 5% but the inflation rate was only 1.61% so the real mortgage rate in 1998 was 7% – 5% – 1.6% or 0.4% which compared to the cost of renting was still a bargain.

And finally we can see the historical real mortgage rate from 1971 through the present. We can see that when it is negative housing is a bargain and the higher the positive number the more expensive housing is in real terms with the recent 2008 spike taking housing costs in real terms to new highs (due to losses due to home ownership).

Unfortunately, for current home owners the inflation adjusted real mortgage rate is still in expensive territory on a historical basis but that doesn’t mean that it isn’t a good time to buy.

In the Mortgage, Inflation, and Housing Appreciation Chart we can see the various factors that when combined compose the Real Mortgage Rates.

If we look at the housing appreciation line (purple) we can see that the best time to buy was in 1990 as housing steadily appreciated from there until it peaked in 2005. Looking at the above chart we see that 1990 was very close to the peak in real mortgage rates as well. So buy buying at the peak and selling when real mortgage rates become excessively low you can actually make the most profit on real estate. In other words, buy when everyone else is selling and sell when everyone else is buying.

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